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Index-based funds may not be all they’ve been cracked up to be

Risks could stem from naked short selling

By N Balakrishnan

When it comes to investing other people’s money, two words, used for more than a century in financial markets, sum up the process and problems. The words are "mutual" more commonly used in the US and "trust" more commonly used in the UK. It is all about pooling the money of many people for "mutual" benefit and then "trusting" someone to take care of it.

The problem with such arrangements is that it is difficult to devise a mutually accepted formula for deciding the risks and rewards for all members. And some people always betray the trust placed on them. This is the crux of the problems in the financial industry and it will always be with us.

But there will be changes too. When this august publication began 15 years ago, "Asia" was expected to overtake the "West". At that time Asia included Southeast Asian countries such as Malaysia and Thailand in prominent positions with China given only marginal weight. No one was suggesting then, as they are now, that China will be saving the entire world with its "stimulus". So it is still "Asia" that is getting the limelight but some parts such as the Southeast have fallen off the radar with China getting most of the prominence and some new entries such as India coming into the "Asian" equation.

Hedge funds were largely unknown in Asia at that time, and even in New York and London, they were vehicles that were reserved for only the very wealthy. Perhaps they should have remained so. I remember that George Soros had just one person working for him in Hong Kong, and he was working out of the offices of the investment company Peregrine! Now hedge funds are all over the place and all one needs to do it seems is to stick the word "hedge" on it and one can start charging a double digit "performance fee".

The secretive world of hedge funds was blown open by the collapse of long-term fund management and its bailout in the US. Hedge funds were vilified, not least by the ex-Prime Minister of Malaysia, Mahathir Mohamad, for "attacking" currencies that led to economic collapse. Calls to "regulate" (read tax) hedge funds were particularly virulent after the Asian financial crisis of 1997. But it was not the hedge funds that caused the latest financial crisis in 2008 but the well-regulated and venerable "commercial banks" and boring old insurance companies such as AIG that brought the financial markets to its knees.

As we look forward to the next 15 years it is worth asking where the next triggers for the financial crisis are going to come from. Now that the regulators have woken up to sub-prime loans and CDOs, it is quite unlikely that the next crisis is likely to originate from there.

We may be better off looking elsewhere for future danger - even places being hailed as risk free innovations. It is always a thankless task to play Cassandra and one does not wish to sound alarmist. Nevertheless, it is worth remembering that both LTCM and sub-prime loans were once praised for reducing risks.

Two innovations that are getting more popular and are being hailed for their risk reducing roles are worth watching - the increasing shift towards "index investing" and the phenomenally popular exchange traded funds (ETFs).

There has always been something illogical about the idea that one should just passively "track" the index, safe in the knowledge that there will always be other fools who will do the heavy lifting of investing actively and incur the transaction costs that go with that.

But as Jeffrey Wurgler, Nomura professor of finance at New York University, has pointed out; when more and more money is tracking stock indices, returns are being artificially skewed based on whether a particular share is in the index rather than because of the performance of the company that has issued the share.

There is also the obvious fact that index investing has to be "self limiting" since 100% of the funds cannot be invested passively. What strikes an impartial observer is that index investing is actually another version of "greater fool theory", since it assumes that others will be investing actively. Also, no one knows or is going to ring the bell to tell the investor in indexing what the optimal level of index investing is. And as we have seen in the past, practices which assume that there will always be greater fools and which are unregulated can lead to trouble.

Though it is being sold as a safe and cheap way to invest, index investing is actually more like a giant derivative on active investments. The index investing industry is something the regulators may need to watch but will probably only do so after at least some damage has been done.

The ETF was invented just a couple of years before this magazine began publishing. As it is a good idea, it has grown explosively. Like any good idea, initially ETFs were used for the good purpose of allowing the retail investor to own entire indices cheaply and provide market liquidity. As ETFs proliferated and now account for a substantial portion of the trading volume of the NYSE, ETFs seem to be acquiring some bad habits.

Andrew A Bogan, of Bogan Associates, a global equity fund management firm based in Boston, pointed out recently the worrying level of "short interest" in ETFs. ETFs are not really structured to deal with this increasing short interest and at some point, this may lead to unpredictable consequences.

For example, an ETF may have only ten million shares but "naked" short sellers are now adding as much as 500% more shares to some. The ETF "receiving" these often non-existent shares then "sell" them to investors who want to go long on the underlying shares. The buyers of ETFs are often unaware that the shares they are buying are coming from short sellers of the ETFs, or that such shares may not even exist. What would happen if all the "long" buyers decided to redeem their shares at the same time is a concern that is just beginning to be discussed.

Mr. Bogan, and his wife Elizabeth Bogan, who have studied the question of short interest in ETFs, say that it is too complicated to figure out the scenario if very large redemptions occur that exceed the number of shares being directly held by the ETF. Once the ETF has redeemed all the shares it directly owns, it will have to be wound up, but it is not clear whether it can collect additional shares from the short sellers, especially the "naked" short sellers in order to meet all redemptions.

Even academics and fund managers are just beginning to wake up to the risks associated with the naked short selling of ETFs. It will be a long while before the regulators get to it and if past practices are any guide, regulations will only come about after a crisis.

Regardless of where the next financial crisis is going to come from, the financial markets and the world will survive them to thrive once more. As John Templeton once pointed out, markets have survived wars and nuclear bomb attacks and have proved resilient. So while the risks are always there, there is also resiliency. And this publication will continue to chronicle both for the next 15 years and beyond.